Trust Issues: Pre- and Post-Nuptial Clauses

If in connection with any joint income tax returns filed by the couple heretofore or hereafter, there is any deficiency assessment, the amount ultimately determined to be due thereon, including penalties and interest, shall be paid by the parties in proportion to his/her income (which may include income of pass through trusts or entities that are not treated as martial income), unless and to the extent that same has been caused by the failure or neglect of a party to disclose any income which should have been included in such returns, in which event and to that extent the party so failing or neglecting to disclose shall bear such expense to the extent allocable to such failure or neglect. Each party agrees to cooperate fully with the other in the event of any audit or examination by a taxing authority of the said joint tax returns and agrees to furnish to the party being examined or his or her designees, promptly and without charge, such authorizations, powers of attorney, papers, records, documents and information as may be reasonably appropriate in connection with such audit or examination; however, in the event of any trust or pass through entity whose income is reflected on the joint income tax return but excluded as non-marital income hereunder, the spouse to whom such income belongs, or the trustee, officer, director, manager or other appropriate person of such trust or entity of that spouse, shall handle such audit. In the event a refund is hereafter paid under the parties' joint income tax returns, the refund shall be divided by the parties in the same proportion as their respective Separate Property shall have generated such refund for the respective year.

If either party has a trust that is characterized as a grantor trust, or an interest in a pass-through entity, or any income from separate property, and if the other spouse's assets are used to pay for income tax on income attributable to such separate property, then such payment of taxes shall not provide any right or claim to the subject entity, trust or property. Rather, to the extent that a spouse's assets are used to pay taxes on income attributable to the other spouse's separate property, he/she shall be entitled to reimbursement in an amount equal to the taxes paid in connection thereto. If either party is a grantor of a trust that permits now or in the future the trustee to reimburse that spouse as grantor for income tax costs he or she paid on income from the trust, neither party shall have any right to demand such reimbursement nor shall either party have any claim if that right to reimbursement is waived or terminated.

Joint Returns?

Should clients be advised not to file a joint return? It depends on the circumstances. The joint return will show flow-through income from family entities and trusts. It may be more prudent when there is flow-through income from family entities and trusts to file as married filing separately in order to make it even more clear cut that such income is a party's separate property in the event of a divorce. If the parties believe that there will be savings from married-filing-jointly status that they are unwilling to forgo, then perhaps a more detailed mechanism can be specified in the marital agreement regarding tax payments. Each spouse could (and really should) hire his or her own CPA. Each party's CPA should then collect relevant tax information and submit it in the form of a Married Filing Separate return to an independent CPA selected each year by the couple. That CPA would then prepare a Married Filing Joint income tax return from the Married Filing Separate return data provided by each separate CPA. If the couple cannot agree on an independent CPA to complete and file the Married Filing Joint return, then they should file Married Filing Separate returns for that year. As part of the engagement to prepare the Married Filing Separate return, the CPA should also determine a reasonable allocation of the overall tax liability for the year attributable to each party and any entities or trusts from which they reported income, and determine how much each party must contribute or receive for that tax year.

Further Assurances and Additional Documents

A common point in martial agreements is obtaining a commitment by the parties to execute further documents. Such a provision might read: Upon the request of either party or of his or her Fiduciaries, the other party, or his or her Fiduciaries, as appropriate, will promptly execute, acknowledge, if requested, and deliver to the other party or to his or her Fiduciaries, as appropriate, any and all further documents necessary, and take such other action, that may be appropriate or expedient to effectuate the provisions of this Agreement, including such instruments as may by required by the laws (now in effect or hereinafter enacted) in any domestic or foreign jurisdiction that may affect the property rights of the parties between themselves or with others.

Binding Effect

“The provisions of this Agreement are binding upon the parties and upon their respective Fiduciaries.”

Provisions like the above are often included in marital agreements. But should fiduciaries be included? Can they be bound without signing a counterpart to the agreement? What if the trust benefits multiple beneficiaries and not just the spouse? Would it even be appropriate for such a fiduciary to commit to terms under a marital agreement for just one of those beneficiaries? As you can see, caution should be exercised in making a marital agreement applicable to or binding on a fiduciary, especially if the trust instrument is governed by the laws of a different state. For example, you might not want to make an agreement governed by New York law binding on trustees and other fiduciaries of a trust with a situs in Delaware and governed by Delaware law. Applying New York law to a fiduciary could undermine, for example, such a Delaware trust.

Conclusion

The increased flexibility and complexity of modern trusts will require special care and provisions in marital agreements, so practitioners today should exercise care in tailoring pre-nuptial and post-nuptial agreements to reflect the trusts and other estate planning mechanisms of their clients. Only through careful planning and execution of these agreements can a multitude of unintended trust-related consequences be avoided.

*****
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration. Rebecca A. Provder is a partner in the Matrimonial and Family Law practice group at Moses & Singer LLP.

Editor's note: The authors conclude herein their discussion, begun in last month's newsletter, of the trust issues that can arise in the context of matrimonial practice.

Tax Returns

Tax returns are a common issue addressed in matrimonial agreements. These provisions should contemplate a range of trust considerations — often more than some practitioners might initially think. For example, a common trust structure is referred to as a “grantor” or “defective” trust in which the settlor creating the trust is taxed on all trust income. Another technique, referred to as a beneficiary defective irrevocable trust or a “BDIT,” is created by a third party, such as a client's mother, but structured so that the beneficiary (e.g., your client) is taxed on trust income even though not the grantor. Some of these trusts (if formed in a jurisdiction that permits this right) may include a tax reimbursement clause that provides an independent trustee the authority, but not the requirement, to reimburse for taxes. This power might also be surrendered (turned off), or triggered (i.e., not effective initially but made effective after the trust was initially formed, and perhaps after the matrimonial agreement was executed). The variability of these provisions can make drafting a matrimonial agreement complex, but administering it even more so. The following is sample language for marital agreements pertaining to how income tax payments and refunds should be allocated by the parties:

If in connection with any joint income tax returns filed by the couple heretofore or hereafter, there is any deficiency assessment, the amount ultimately determined to be due thereon, including penalties and interest, shall be paid by the parties in proportion to his/her income (which may include income of pass through trusts or entities that are not treated as martial income), unless and to the extent that same has been caused by the failure or neglect of a party to disclose any income which should have been included in such returns, in which event and to that extent the party so failing or neglecting to disclose shall bear such expense to the extent allocable to such failure or neglect. Each party agrees to cooperate fully with the other in the event of any audit or examination by a taxing authority of the said joint tax returns and agrees to furnish to the party being examined or his or her designees, promptly and without charge, such authorizations, powers of attorney, papers, records, documents and information as may be reasonably appropriate in connection with such audit or examination; however, in the event of any trust or pass through entity whose income is reflected on the joint income tax return but excluded as non-marital income hereunder, the spouse to whom such income belongs, or the trustee, officer, director, manager or other appropriate person of such trust or entity of that spouse, shall handle such audit. In the event a refund is hereafter paid under the parties' joint income tax returns, the refund shall be divided by the parties in the same proportion as their respective Separate Property shall have generated such refund for the respective year.

If either party has a trust that is characterized as a grantor trust, or an interest in a pass-through entity, or any income from separate property, and if the other spouse's assets are used to pay for income tax on income attributable to such separate property, then such payment of taxes shall not provide any right or claim to the subject entity, trust or property. Rather, to the extent that a spouse's assets are used to pay taxes on income attributable to the other spouse's separate property, he/she shall be entitled to reimbursement in an amount equal to the taxes paid in connection thereto. If either party is a grantor of a trust that permits now or in the future the trustee to reimburse that spouse as grantor for income tax costs he or she paid on income from the trust, neither party shall have any right to demand such reimbursement nor shall either party have any claim if that right to reimbursement is waived or terminated.

Joint Returns?

Should clients be advised not to file a joint return? It depends on the circumstances. The joint return will show flow-through income from family entities and trusts. It may be more prudent when there is flow-through income from family entities and trusts to file as married filing separately in order to make it even more clear cut that such income is a party's separate property in the event of a divorce. If the parties believe that there will be savings from married-filing-jointly status that they are unwilling to forgo, then perhaps a more detailed mechanism can be specified in the marital agreement regarding tax payments. Each spouse could (and really should) hire his or her own CPA. Each party's CPA should then collect relevant tax information and submit it in the form of a Married Filing Separate return to an independent CPA selected each year by the couple. That CPA would then prepare a Married Filing Joint income tax return from the Married Filing Separate return data provided by each separate CPA. If the couple cannot agree on an independent CPA to complete and file the Married Filing Joint return, then they should file Married Filing Separate returns for that year. As part of the engagement to prepare the Married Filing Separate return, the CPA should also determine a reasonable allocation of the overall tax liability for the year attributable to each party and any entities or trusts from which they reported income, and determine how much each party must contribute or receive for that tax year.

Further Assurances and Additional Documents

A common point in martial agreements is obtaining a commitment by the parties to execute further documents. Such a provision might read: Upon the request of either party or of his or her Fiduciaries, the other party, or his or her Fiduciaries, as appropriate, will promptly execute, acknowledge, if requested, and deliver to the other party or to his or her Fiduciaries, as appropriate, any and all further documents necessary, and take such other action, that may be appropriate or expedient to effectuate the provisions of this Agreement, including such instruments as may by required by the laws (now in effect or hereinafter enacted) in any domestic or foreign jurisdiction that may affect the property rights of the parties between themselves or with others.

Binding Effect

“The provisions of this Agreement are binding upon the parties and upon their respective Fiduciaries.”

Provisions like the above are often included in marital agreements. But should fiduciaries be included? Can they be bound without signing a counterpart to the agreement? What if the trust benefits multiple beneficiaries and not just the spouse? Would it even be appropriate for such a fiduciary to commit to terms under a marital agreement for just one of those beneficiaries? As you can see, caution should be exercised in making a marital agreement applicable to or binding on a fiduciary, especially if the trust instrument is governed by the laws of a different state. For example, you might not want to make an agreement governed by New York law binding on trustees and other fiduciaries of a trust with a situs in Delaware and governed by Delaware law. Applying New York law to a fiduciary could undermine, for example, such a Delaware trust.

Conclusion

The increased flexibility and complexity of modern trusts will require special care and provisions in marital agreements, so practitioners today should exercise care in tailoring pre-nuptial and post-nuptial agreements to reflect the trusts and other estate planning mechanisms of their clients. Only through careful planning and execution of these agreements can a multitude of unintended trust-related consequences be avoided.

*****
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration. Rebecca A. Provder is a partner in the Matrimonial and Family Law practice group at Moses & Singer LLP.